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Is a Rising Yield Curve Bullish or Bearish?

July 24, 2013
Chad Karnes, Chief Market Strategist

Add the yield curve to a long list of concerns for the rising stock market (NYSEARCA:DIA).

This past month’s bond rout (NYSEARCA:AGG) has done more than just raise interest rates, it has raised the yield curve, and historically that has not been a good thing for the equity markets.

As usual, though, the mainstream media and experts are getting it wrong when it comes to a steepening yield curve.

ING Investment Management recently exclaimed concerning a steepening yield curve, “Over the next couple of years, equity returns will start to outperform fixed income returns. We are also seeing yield curves steepening, which is also positive for cyclical and value equities.”

Another headline states, “Nothing bankers like more than a steepening yield curve”.

ING and the other so called experts need to look at the chart below (or any chart for that matter), as history begs to differ.

The History of the Yield Curve

As the yield curve steepens, the difference or spread between long-term and short-term interest rates increases. This causes long-term bonds to decrease in value relative to bonds with shorter maturities.

The chart below along with our outlook for Treasuries was recently provided to subscribers of our ETF Profit Strategy Newsletter and shows the ten year (NYSEARCA:IEF) less the two year (NYSEARCA:SHY) Treasury yield spread in red (also known as the yield curve).

The S&P 500 (NYSEARCA:SPY) is also shown in blue for comparison. Over the past 25 years, the yield curve has started steepening sharply three times, in 1990, 2000, and 2007. If these dates don’t scare you, they should, as they all marked significant equity price and economic peaks.

The vertical lines in blue mark the yield curve bottoms that occurred just before the recent quick steepenings of the yield curve. Every time the curve steepened sharply, the market soon after peaked.

Contrary to popular belief, a steepening yield curve is not bullish for equities.

Theory Does not Reflect Reality

Many pundits and economists will suggest that a steepening yield curve is “good for the economy” as it’s a sign of future growth and inflation. Ignore them and their theories.

One justification they provide is that the steepening yield curve is great for banks and thus great for the economy. From the Wall Street Journal, “The steepening is definitely good for banks, as banks (NYSEARCA:FAS) these days make their money on the net income margin”. Well, if it’s good for banks (NYSEARCA:XLF), it stops at their margins as their stocks got creamed during previous curve steepenings (in reality their margins were not improved during previous steepenings).

Another popular argument is that a rising yield curve suggests an improving economic environment as Business Insider recently suggested, “When yields are rising from a low level, they reflect improving prospects for economic growth”. Maybe in theory, but a glance at reality suggests otherwise.

Profiting from the Curve

A better explanation for a steepening yield curve may be a dash for cash. A steepening yield curve means the ten year Treasury price is falling faster than the two year. As the yield curve steepens more money is being sent into the safer, less volatile shorter end of the curve as opposed to the longer end. This drives the curve higher and suggests that during times of steepening, fear and a rush for safety are actually dominating the markets. This makes more sense given the equity market declines that have soon followed.

This is why we have been suggesting to our subscribers a move into the shorter-term Treasuries such as SHY and IEF (NYSEARCA:IEF). In our twice weekly Technical Forecast after Bernanke’s testimony on 5/22 we wrote:

“The Fed spooked Treasuries today and the IEF now closed below its 200 day moving average. The medium term uptrend in bonds is over.”

We followed up on 6/12 by writing:

“SHY shows how little the short end of the Treasury curve has been affected by the recent bond scare. Parking your money here keeps the downside risk much smaller than JNK (NYSEARCA:JNK), HYD (NYSEARCA:HYD), MUB (NYSEARCA:MUB), or even TLT (NYSEARCA:TLT)."

Since our 5/22 alert, 2x and 3x inverse long-term Treasury bond ETFs (NYSEARCA:TBT) have surged between 11% and 15.37%. By comparison, the total U.S. bond market has been dead money in 2013 and is down 3% year-to-date. Our alert about moving into SHY alone saved TLT investors over 5% of losses!

Besides moving to safer shorter-dated Treasuries, another way to play a steepening curve is to buy the iPath Treasury Steepener ETN (NYSEARCA:STPP). It has already rallied over 15% since May and would benefit if the yield curve keeps steepening. Past steepenings have sent the yield curve over 250 basis points higher from its lows. If that again is the case, then the yield curve still would have over 150 basis points of move higher, providing a windfall for STPP owners.

More aggressive traders or yield curve hedgers may also look into the iPath 10 Year Bear ETN (NYSEARCA:DTYS). This product aims to move inversely to the 10-year Treasury and should capitalize on a continued deterioration of Treasuries.

The ETF Profit Strategy Newsletter focuses on fundamentals, technicals, sentiment, and common sense to stay ahead of the markets. Join us today for more high probability trade setups.

On May 1, 2013, the bond vigilantes called the Interest Rate on the US Ten Year Note, $TNX, higher from 1.63, commencing an Elliott Wave 3 Up Wave in the Benchmark Interest Rate. The Third Wave is the most sweeping of all economic waves as it alternatively creates or destroys the bulk of all wealth on the way up Its Crest at the Top of Wave 5. In this case the wave will create wealth for those owning Interest Rate Swaps, that is primarily the US Fed primary dealers, and destroys the investor’s Stock Wealth, VT.

On December 6, 2013, the final phase of the business cycle, known as Kondratieff Winter, commenced at the hands of the bond vigilantes, where recession operates via monetary deflation, that is the fall lower in the value of money, as well as the accumulation of money, like the pile of M2 Money, dwindling lower in nominal value, from its peak of 10,988 on 10-21-2013 to 10,934 as of 11-25-2013, and investment deflation, as investors derisk, as is seen in the Risk Off ETN, OFF, rising in value, a sharp stock market sell off, a sharp economic recession, then an all out credit bust and financial system breakdown.

Tapering, that is, further US central bank monetary stimulus, cannot help and will not help; further monetary stimulus will only strengthen the hand of the bond vigilantes who have been calling the Benchmark Interest Rate, ^TNX, higher since October 23, 2013, as the policies have crossed the rubicon of sound monetary and have made “money good” debt, and “money good” currencies, and now “money good” fiat wealth, that is World Stocks, VT, bad.

Writing in Zero Hedge, Asia Confidential posts Why Japan may matter more than tapering. Japan is likely to launch even more QE in early 2014 and a much lower yen may result. That'll have dramatic consequences, perhaps greater than US tapering.

Liberalism was both a paradigm and an age of investment choice, that featured the investor; it came to an end through the death of fiat money, that is Aggregate Credit, AGG, and Major World Currencies, DBV, and Emerging Market Currencies, CEW, by the bond vigilantes steepening the 10 30 US Sovereign Debt Yield Curve, $TNX:$TYX, seen in the Steepner ETF, STPP, and calling the Interest Rate on The US Ten Year Note, ^TNX, higher from 2.48% on October 23, which finally translated death to fiat wealth, that is Global Financials, IXG, Nation Investment, EFA, and World Stocks, VT, on December 2, 2013, when the Benchmark Rate, rose from 2.74%; thus fiat wealth died on December 2, 2013, terminating liberalism.

The death of fiat money, on October 23, 2013, and the death of fiat wealth, on December 2, 2013, are the “genesis factors” of three things: 1) a sharp stock market sell off. 2) a sharp economic recession. And 3) a credit bust and financial system breakdown.

Perhaps one might enjoy reading my latest post
The World Pivots From Liberalism Into Authoritarianism On The Death Of Fiat Wealth As Bond Vigilantes Call The Interest Rate On The US Ten Year Note Higher To 2.84% is posted on the Internet here http://tinyurl.com/lpnuuh2

Jersey Guy said on August 04, 2013

What I find interesting is that yields have risen in the face of QE infinity, which has not happen throughout the FEDs QE purchases. If Wall Street supply out strips public demand, yields will go up.

Europe continues to sit on a ton of debt that WILL not go away, China is transforming its economy and Japan is facing bankruptcy (if you believe Kyle Bass). At some point the risk will force you into the bond market at an attractive price (2.75 - 3.0 % on the ten year).

The low hanging fruit for the US economy has been had (ie., housing bounce, increased auto sales, aircraft sales) over the last five years. There are more temperary service jobs now more than ever, government worker have been laid off at record rates and wages are still flat to down. The global economy is going through a "Baby Boom" malaise as delflation continues to haunt the FED......

Jersey Guy said on August 04, 2013

The Fed will "NOT" lost anything as long as the Bonds are held to maturity, which means you get your principle back. The FED is not buying BOND to profit, so they can hold them for 30 years and recover their costs (expanded balancesheet).

Walter said on July 25, 2013

It's crazy Skull. What a way to run a country...

Bernumb-SKULL said on July 25, 2013

Hey Walter, did you know the Fed suffers approximately $3 billion in losses for every 0.01% rise in rates? As the holder of long-term Treasuries that's what they get. How much have they lost over the past year from falling Treasury bonds?! My calculator doesn't go that high.

Walter said on July 24, 2013

If only the Bernanke Funny Money wasn't coercing the market then "the past" would make more sense and be more relevant. Bad news? Market up. Bad earnings? Market up. The Fed's market manipulation makes it hard to know what matters these days. Nothing will matter except the Fed until it does matter, then I have a feeling the market will be on a swift ride down.

grant8 said on July 24, 2013

Thank you Chad for clearly explaining the relationship between rates on long and short term bonds and de-mystifying the yield curve! Also, I appreciate the heads up notice to bail on TLT. My current position is zero percent!